British Pound Could Rally Ahead of Bank of England Rates Decision

 | Sep 08, 2017 | 9:00 AM EDT
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If you're looking to trade the British pound short term, next week would be ideal for some quick trades. On Tuesday, consumer price inflation data are released, and on Thursday the Bank of England's monetary policy committee will announce its decision on interest rates.

Both days have the potential to surprise, although it doesn't necessarily mean they will. The pound took such a tumble in August that inflation could come in higher than the expected 2.7%. And the Bank of England is under increased pressure to raise interest rates from their historic low of 0.25%.

The main arguments in favor of low interest rates have been that they boost growth by encouraging borrowing and therefore consumption and that they weaken the pound, making British exports more competitive. Both are no longer valid.

Consumer confidence fell to levels last seen after the result of the June 2016 referendum in which the British voted to leave the European Union as price increases have squeezed consumers.

Although a survey released on Friday by accountancy firm BDO showed that like-for-like sales values rose by 2% in August -- the biggest rise in two years -- the increase is likely due to products costing more rather than shoppers buying more of them.

Indeed, a survey released by the British Retail Consortium earlier this week showed that growth in retail sales in terms of volume was weaker than last year even though like-for-like sales were 1.3% up in terms of values.

The British Chamber of Commerce (BCC) downgraded its medium-term outlook for the U.K. economy on Friday, saying that inflation is forecast to outpace average earnings until 2019, which will weigh on consumer spending.

Cheap British pound does not equal export boom

The chamber also said the contribution of net trade to GDP growth is not likely to be as strong as the BCC had expected, as there is little evidence that the pound's depreciation is boosting British exports materially or that consumers and firms replace imported goods with domestic alternatives.

"Our forecast suggests that the hoped-for rebalancing of the U.K. economy towards investment and export is unlikely to materialize in the medium term," Adam Marshall, BCC director general, said in a statement. "A cheaper currency does not automatically mean an export boom, no matter how some politicians and commentators will it to happen."

There are several arguments in favor of an interest rate hike. Unemployment, at 4.4%, is below the Bank of England's level of equilibrium unemployment, which is 4.5%, as analysts at Standard Life Investment noted in recent research. They say the U.K. labor market is "perhaps the biggest elephant in the room."

There is a "significant shortage" of people to fill blue-collar jobs at the moment, according to a survey by IHS Markit and the Recruitment and Employment Confederation (REC), which showed demand for staff in August rose at the fastest pace since April 2015. This shortage is likely to lead to an increase in wages, which in turn will push inflation that already is above target even higher.

At the latest Bank of England monetary policy committee meeting, only two members of the eight voted for a rise in interest rates. One of them, former Citigroup economist Michael Saunders, said in a speech at the end of August: "Our foot no longer needs to be quite so firmly on the accelerator in my view. A modest rise in rates would help ensure a sustainable return of inflation to target over time."

Will most of the committee come around to that view by next Thursday? That is unlikely, but not as unlikely as not to warrant some speculative appreciation of the pound ahead of the event. Already, the British pound is up 1.5% to the dollar and 1.4% to the euro since the end of August, a sign that some traders believe the British currency is now undervalued.

Expect sterling's strength to continue, at least until next Thursday's Bank of England monetary policy announcement, bar any major Brexit news.

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